Is Audit Quality Higher When Audit Committees Report Strong Oversight? Free

B,ratten et al. (2022) test two competing theories that predict the association between audit committee–reported oversight and audit quality. On one hand, agency theory defines agency costs as those that arise due to the separation of ownership and control and suggests that these costs can be mitigated with effective monitoring (Jensen and Meckling 1976). Audit committee directors, as shareholder representatives, are expected to exercise strong and effective monitoring of management practices and decisions. Agency theory thus predicts audit quality will be higher when audit committees report stronger oversight. On the other hand, institutional theory posits that audit committees play a mere ceremonial role in corporate governance (Powell 1991). Institutional theory thus predicts that voluntarily reported oversight may be window dressing directed to appease investors, suggesting no incremental increase in the quality of the audit process.

Using data provided by Audit Analytics that summarize the audit committees’ reported oversight, Bratten et al. (2022) set out to answer the question of whether the reported activities enhance audit quality and whether they are valued by investors. The study finds a positive and significant association between the extent of reported oversight and audit quality using multiple proxies and multiple regression methods. The results suggest that reported oversight represents diligent effort on the part of audit committees on selecting, compensating, and evaluating the work of the auditor rather than representing “cheap talk” that merely attempts to manage investor perceptions.

We provide a summary of Bratten et al. (2022), illustrate some of the disclosure measures with examples from practice, and discuss the implications of the study’s findings for practice.

The corporate scandals of the early 2000s raised concerns about the reliability of financial disclosures and the adequacy of the regulation of the audit function. To restore investor confidence in the capital markets, Congress enacted the Sarbanes-Oxley Act of 2002 and the Securities and Exchange Commission (SEC) implemented rules that strengthened and expanded the role of the audit committee in overseeing an issuer’s external auditor. Currently, the audit committee is directly responsible for the appointment, compensation, and evaluation of the work of the auditor. As an intermediary between management and the external auditor, the audit committee has strategic importance in the auditing process.

Although the audit committees’ oversight role has been expanding, requirements to report on this oversight have not changed substantively since 1999, when in response to recommendations from the Blue Ribbon Committee, the SEC adopted disclosure rules requiring audit committees to include a report in the proxy statement to shareholders. Currently, the audit committee is not required to provide information about the process of selecting the auditor or about how the committee evaluated the work of the auditor. Although audit committees are required to disclose professional attributes, such as financial expertise, early studies reveal that even audit committees with impressive professional attributes may not be effective in fulfilling their oversight duties (Beasley, Carcello, Hermanson, and Neal 2009).

Financial statements’ users—starting with the United Brotherhood of Carpenters in the 2012 proxy season—have called for more information on how audit committees perform their oversight duties when protecting investors’ interests (Rutherford and Sharma 2013). Several nationally recognized U.S. governance organizations came together to assist audit committees in the oversight of the external auditor and “encouraged all public company audit committees to thoughtfully reassess their reporting and communication with stakeholders and, if need be, to strengthen them in the future.”¹ The SEC weighed in by issuing a concept release titled “Possible Revisions to Audit Committee Disclosures” in July 2015.² Noting an interest in improving the communication coming from audit committees, the SEC requested public comments to better understand whether additional reporting related to oversight of the auditor would promote audit quality and whether it would be useful to investors.

In response to investor calls for information and regulators’ interest in potential new requirements, many audit committees started voluntarily providing additional information on how they perform their auditor oversight duties. Using textual analysis, Draeger, Lawson, and Schmidt (2023) report that audit committees of large accelerated filers increased the disclosure of their audit oversight activities following the SEC’s 2015 Concept Release. In a survey based on disclosures in audit committee reports and proxy statements of issuers in the S&P 1500 composite, Audit Analytics and the Center for Audit Quality report increasing trends in oversight disclosures Center for Audit Quality and Audit Analytics (CAQ and AA) (2017).

Bratten et al. (2022) examine whether there is substance behind voluntary disclosures by audit committees on auditor oversight. If there is substance, more reported activities imply better audit quality, on average. Alternatively, if audit committees largely window dress their proxy statements, then there should not be a significant relationship between reported activities and audit quality.

Audit Analytics developed a taxonomy of disclosure items that tracks 11 audit committee activities that are voluntarily reported in a Report of the Audit Committee or elsewhere in an issuer’s proxy statement, which relate to three aspects of auditor oversight: selection, compensation, and evaluation. See  Appendix A for details related to how each aspect is defined.³

Selection is based on disclosures about the length of time the auditor has been engaged, involvement and considerations of audit committee in appointing the external auditor, and audit partner rotation. For example, Bratten et al. (2022, 27–28) include a disclosure example from the Audit Committee of Tetra Tech, Inc. In 2016, Tetra Tech reported that PwC had served as their auditor since 2004, that the Audit Committee is involved “in the interview and selection process of any new lead audit partner,” and that, in order to “bring a fresh perspective to the audit engagement,” a new lead partner was designated at the beginning of fiscal 2015. Also, “in determining whether to reappoint PwC, [Tetra Tech’s] Audit Committee considered the qualifications, performance, and independence of the firm and the audit engagement team, the quality of its discussions with PwC, and the fees charged by PwC for the level and quality of services provided.”

Compensation is based on disclosures about the audit committee’s responsibility for fee negotiations, the impact of nonaudit services on auditor independence, and any eventual changes in fees paid to the auditor. For example, the Audit Committee of Tenet Healthcare Corp. disclosed in 2017 that it is “responsible for the audit fee negotiations associated with the retention of Deloitte,” that it “understand[s] the need for Deloitte to maintain objectivity and independence,” and that one factor it considered was “whether the non-audit services were compatible with the firm’s independence.” The Committee had established a policy concerning the nonaudit services performed by the auditor that imposes a “specific annual limit on the amount of non-audit services” and has a preapproval process for nonaudit services (e.g., tax compliance, planning, and consultations; acquisition/disposition services; attestation and agreed upon procedures; etc.). The disclosure also includes a table showing the fees for audit and other services provided by Deloitte, comparatively for 2016 and 2015, and clarifies the services for each of those fees.

Evaluation is based on disclosures of the significant areas addressed with the auditor, the discussion of the general oversight of the auditor, whether the evaluation occurs at least annually, and the criteria considered for the evaluation. For example, in 2017, the Audit Committee of Walgreens Boots Alliance, Inc. disclosed that it had discussed with Deloitte (the auditor) “the quality of the Company’s accounting principles; the reasonableness of its critical accounting estimates and judgments; the disclosures in its financial statements, including disclosures relating to significant accounting policies” and “significant disputes with management, if any.” The disclosures also mention that “the purpose of Audit Committee includes assisting the Board in the oversight and monitoring” of the auditor and that the Committee reviews the performance of the auditor annually. Walgreens Boots Alliance’s audit committee also disclosed a detailed list of eight specific factors it considered “when conducting its latest review Deloitte.”⁴

Bratten et al. (2022) create a comprehensive variable—Oversight—that captures all three of these aspects of oversight and set it equal to the sum of the three components. To capture the multifaceted construct of audit quality, the study uses several measures categorized as input based, output based, and perception based (DeFond and Zhang 2014).⁵

Audit fees are an input in the audit process (Hay, Knechel, and Wong 2006) and are used as the first proxy for audit quality in Bratten et al. (2022). The intuition is that higher fees capture higher levels of audit effort, which would be present when audit committees demand higher levels of assurance.

The study also uses three outputs of the audit process to capture audit quality, specifically issuers’ discretionary accruals, propensity to meet or just beat earnings benchmarks, and subsequent accounting restatements (Item 4.02 in an 8-K). Discretionary accruals are a proxy for earnings management and are measured as the part of accruals that cannot be explained by an issuer’s operations (Jones 1991; Dechow, Sloan, and Sweeney 1995; Kothari, Leone, and Wasley 2005).⁶ Therefore, lower discretionary accruals imply higher audit quality, since a high-quality audit would be more likely to prevent management from using accruals for earnings manipulation. The rationale behind the second output-based measure, the propensity to meet or just beat earnings benchmarks, is that a high-quality audit prevents management from making opportunistic accounting adjustments, mitigating earnings management intended to meet or exceed expectations. Therefore, a lower propensity to report earnings that meet or just beat the benchmark implies higher audit quality. The last output-based measure of audit quality, subsequent restatements of previously issued financial statements, captures cases when a material accounting mis-statement occurs in a given period. A lower likelihood of restatements implies higher audit quality.

Finally, the study controls for other factors potentially affecting audit quality by including measures of issuer characteristics (e.g., size, growth, complexity, financial distress, performance, etc.), board and audit committee characteristics (e.g., number of meetings, financial expertise, board independence, etc.), environment characteristics (e.g., institutional investors, financial analyst following the issuer, etc.), and other information that might be reported simultaneously with audit committee reports (e.g., directors and executive compensation, auditor change, etc.). See  Appendix B for details about how each measure is calculated.⁷

Table 1 presents an excerpt of the descriptive statistics of the sample of issuers in Bratten et al. (2022).⁸ As depicted, the reported oversight activities range from 1 to 9, and the average issuer in the sample discloses that their audit committees engage in about 3 to 4 oversight activities. This includes an average of 1 to 1.3 activities in each of the three aspects of oversight—selection, compensation, and evaluation. On average, 61 percent of the members of audit committees are identified as financial experts as tracked by the Institutional Shareholder Services (ISS). About 92 percent of the sample issuers are audited by a Big4 accounting firm, which is understandable since the sample is drawn from the S&P 1500 composite. On average, issuers have positive performance and liquidity measured by the return on assets (Roa) and cash from operations (Cfo), respectively.

Using several regression methods, Bratten et al. (2022) find a positive and significant association between audit committee oversight and the audit fees proxy for audit quality. When looking at each of the three components of oversight—selection, compensation, and evaluation—results suggest that these associations are primarily driven by reported activities that relate to the selection of the auditor.

Next, the study provides evidence of negative and significant associations between audit committee oversight and discretionary accruals, propensity to meet or just beat earnings benchmarks, and material accounting mis-statements. These findings suggest that the measured oversight activities appear to pay off in that they are associated with a higher level of audit quality, on average.

Bratten et al. (2022) show that reported audit committee activities appear to proxy well for audit committee diligence, likely capturing interactions between the audit committee and the auditor. We thus recommend that auditors consider sharing the results of Bratten et al. (2022) with their clients, and we specifically identify several audit committee activities to consider reporting.

Because Bratten et al. (2022) show that oversight activities related to the selection of the auditor are robustly associated with several proxies for audit quality, we conclude that selection is likely the most important mechanism for ensuring high-quality audits and that devoting time and resources to the auditor selection process may be beneficial. Auditor selection activities that audit committees should consider reporting include how they consider the length of auditor tenure, how they are involved with interviewing and selecting the lead audit partner, and how they consider the qualifications and performance of the engagement team.

Because Bratten et al. (2022) also show a positive association between audit quality and oversight activities related to auditor compensation and evaluation, audit committees may also wish to consider reporting additional actions related to auditor compensation, such as the role of the audit committee in fee negotiations, how they determine whether nonaudit fees impact auditor independence, policies that restrict fees from nonaudit services, and the approval process for nonaudit services. Finally, reporting about auditor evaluation activities may include how audit committees review the auditor’s performance and whether discussions with the auditor include significant areas of concern, disputes with management, and the quality of the accounting estimates and judgments and of the disclosures in the financial statements.

The results of Bratten et al. (2022) should also be informative to the SEC when considering whether to mandate additional disclosure requirements or keep the current voluntary disclosure regime on audit committee oversight. One important caveat is that inferences from a voluntary disclosure regime might not be generalizable to other settings where similar disclosures are mandated.